Module 1: Introduction

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.
Outline Module 1
 What is Economics?
 What is Engineering Economy?
 The Role of Engineering in Shaping the
Economic Environment
 Project Life Cycle
 Some Concepts, Definitions and Terminologies
 Time Value of Money
 Interest and Interest Rate
 Cash Flow

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What is Economics?
 The study of how limited resources are used
to satisfy unlimited human wants.
 The study of how individual and societies
choose to use and utilize scarce resources
 Resources:
 LAND  all gifts of nature that can be applied to
the process (production)
 LABOR  efforts, skills, expertise, knowledge of
people which can be applied to the process
 CAPITAL  human, tools/machineries, financial

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What is Engineering Economy?
 Engineering and the Economy
 Any endeavor, including engineering, will always have
consequences
 Engineering endeavor
 Add value  betterment of effectiveness, efficiency, changing conditions
 Add economic value  the most common comparable measurement
 Example:
 Economic decisions
 A piece of equipment has been used for 10 years as part of important
process. Current condition indicates that service level is slightly
decrease, often breaks down. On the other hand the demand for product
is in constant increase, at least for the next 5 years.
 Alternatives:
 Replaced with a new one or to be repaired
 Current and future technology (?)
 Future demand (?)

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Engineering Economy
 Deals with the concepts and techniques of analysis
useful for evaluating the worth of goods, services,
system in relation to cost
 For engineers, it is used to answer questions such
as:
 Which engineering projects are worthwhile?
 Which engineering projects should have higher priority?
 How should an engineering project be designed?
 The answers based on the concepts of:
 Cash flows (cash in and cash out)
 Interest rate and time value of money
 Equivalent techniques

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The Role of Engineering in Shaping the
Economic Environment
 Engineering Options
 There are many (engineering) alternative solution for
any problem or challenge
 What solution is best to satisfy? For now or anytime in
the future
 How do we compare one to another?
 Engineering Steps
1. Determine objectives
2. Identification of strategic factors
3. Determine means  engineering proposals
4. Evaluation of engineering proposals  cash flow of
alternatives
5. Decision making  economic evaluation
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Project Life Cycle
Concept &
Definition
Phase Next Cycle
Design
Phase
Construction Phase

Level of Change Operation & Maintenance Phase

scope cost

Time

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Time Value of Money
 Purchasing or earning power of money
 Funds borrowed for the prospects of gain are commonly
exchanged for goods, services or instruments of production,
that ultimately leads to increase earning
 Time value of money
 What you could buy with Rp. 1 million a year ago will not be
the same with the ones you buy today.
 Rp. 1 million you invested in a bank a year ago will yield more
when you draw today.
 Rp 1 million today is worth more than a year latter.
 Concept of equivalence  different sums of money at
different time can be equal in economic value.
Rp. 1 Mill P F Rp. 1 Mill
+
interest

0 1 2 3 n-1 n
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Interest and Interest Rate
 Interest is defined as a rental amount charged by financial
institution of the use of money
 Interest rate (also known as rate of capital growth) is defined
as the rate gain received from an investment  measured in %
 Interest rate is determined mutual agreement between the
borrower and the lender, or by market forces involving supply
and demand  market value.
 From lender’s point of view:
 Involves risk of default
 Compensate for not taking other alternative (including for own use)
 Cost of investigating borrower and other administrative expenses
 To make up for inflation
 From borrower’s point of view:
 Based in one’s utility, for personal use
 Based on expected return, for financing operation or investment

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Basic Calculation of Interest
Rp. 1 Mill P F Rp. 1 Mill
+
interest

0 1 2 3 n-1 n

 Original investment  present value (P)

 Total accumulated amount  future value
(F)
 Interest , I = F – P
 Interest rate, i = (interest accrued per unit
time) / (original amount)

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Simple Interest
 Simple interest = (principal)(number of periods)(interest rate), I = P.n.i
 Accumulated amount, F = P + I = P(1+ni)

i=12%
End of Amount Owed Interest Amount Owed Amount
Period at Beginning of Charged at End of Paid at End
(A) Period (C) = (B) x i Period of Period
(B) (D) = (B) + (C)
1 Rp. 1.000.000,- Rp. Rp. Rp. 0
120.000,- 1.120.000,-
2 Rp. 1.120. 000,- Rp. Rp. Rp. 0
120.000,- 1.240.000,-
3 Rp. 1.240.000,- Rp. Rp. Rp. 0
120.000,- 1.360.000,- EXCEL
4 Rp. 1.360.000,- Rp. Rp. Rp.
1-11 120.000,- 1.480.000,-
SI-4251 Ekonomi Teknik Muhamad1.480.000,-
Abduh, Ph.D.
 Compound Interest
 Compound interest  interest will be charged for all unpaid amount
 Accumulated amount, F = P(1+i) n
End of Amount Owed at Interest Amount Owed at Amount Paid
Period Beginning of Charged End of Period at End of
(A) Period (C) = (B) x i (D) = (B) + (C) Period
(B) = (C)n-1 (E)
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 0,-
2 Rp. 1.120. 000,- Rp. 134.400,- Rp. 1.254.400,- Rp. 0,-
3 Rp. 1.254.400,- Rp. 150.528,- Rp. 1.404,928- Rp. 0,-
4 Rp. 1.404.928,- Rp. 168.592,- Rp. 1.573.519,-
Rp.
End of Amount Owed at Interest Amount Owed at End1.573.519,-
of
Period Beginning of Charged Period
Period
1 P Pi P + Pi = P (1+i)1
2 P(1+i) P(1+i) i P(1+i) 1 + P(1+i)i = P (1+i) 2
3 P(1+i) 2 P(1+i) 2i P(1+i) 2 + P(1+i) 2.i = P (1+i) 3
EXCEL
n P(1+i) n-1 P(1+i) n-1i P(1+i) n-1 + P(1+I) n- = P(1+i) n
1
i
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Exercise for Concept of Equivalence
 Loan: $ 5,000, i = 8%, n = 5
 Repayment plans:
 Plan 1: Simple interest, pay all at end.
 Plan 2: Compound interest, pay all at end.
 Plan 3: Simple interest paid annually, principal
repaid at end.
 Plan 4: Compound interest and portion of principal
repaid annually.
 Plan 5: Equal payments of compound interest and
principal made annually.
EXCEL

13 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Cash Flows
 Any undertaking and/or business endeavor
(including engineering projects) generally have
economic consequences that occur over an
extended period of time.
 Each project is described as cash received (inflow
– cash in) or disbursement or expenses (outflow –
cash out) at different point in time.
 Cash Flow Diagram (CFD) summarizes the costs
and benefits of engineering project over time.
CFD illustrates the size, sign and timing of
individual cash flows and form as the basis for
engineering economic analysis

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Cash Flows Diagram
 In a CFD the end of period t is the same as
the beginning of next period t+1
 The choice of time 0 is arbitrary. It can be
when the project is analyzed, when funding
is approved or when the construction
begins

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Homework #1
1.What will be the accumulated amount of Rp 1.750.000,-
compounded annually for three years at the rate of 15% p.a?
2.How much do you have to save now if you’d like to have
Rp. 12.500.000,- to start a new company 3 years
from now at the interest rate of 12% per year?
3.What is the rate of return of an initial investment worth Rp.
30 millions that yield Rp. 45.000.000,- after 3 years?
4.An initial investment of Rp. 50 millions is being considered.
The revenues from this investment are Rp 20
millions at the end of first year, Rp 25 millions and Rp 15
millions at the end of second and third years. If the
alternative will give a revenue of Rp 57,5 millions at the end
of the third year, which investment would you recommend?
The interest rate is set at 10% annually.

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